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FRM Part I · FRM Exam Part I · External and Internal Credit Ratings

A bank backtests its internal rating grade 'B+' over a year. It had 400 obligors in grade B+ at the start of the year, and 14 of them defaulted during the year. The grade's assigned PD is 2.5%. What is the realized default rate and how does it compare with the assigned PD?

The realized default rate is 14 defaults divided by 400 obligors, or 3.5%. That exceeds the assigned PD of 2.5%, so the grade's risk may be underestimated, although statistical testing would be needed to confirm the difference is significant.

  1. A3.5%, higher than the assigned PD, indicating possible underestimation of riskCorrect
  2. B2.5%, equal to the assigned PD
  3. C3.5%, lower than the assigned PD
  4. D14.0%, higher than the assigned PD

Explanation

Realized default rate = 14/400 = 3.5%. This exceeds the assigned 2.5%, suggesting PD may be underestimated (subject to statistical significance). Option D uses the count instead of a rate; option C gets the direction wrong.

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